10/12/2009 @ 12:10PM

Why You Need Commodities

By last Friday afternoon the Administration’s efforts appeared effective. The week long dollar decline was arrested. We may never know how close we came to a run on the Greenback. We shall watch the US dollar with much interest in the next few weeks and months. Sustainable dollar strength emanates fundamentally from higher Fed Funds interest rates or threats thereof. Dr. Bernanke and the most ardent hawks on the FOMC are not prepared to advocate interest rate increases given the fragile US real estate and credit markets.

The following graph reveals the decade-long decline of the US currency relative to its northern Neighbor, the Canadian Loonie. The decline has been as relentless as it has relative to the Euro, the Yen and the Swiss Franc. Pressured by the exploding US budget deficit we expect to see more downward pressure on the dollar. Thus the potential exists for a currency race to the bottom amongst trading partners. One sure approach to mountainous debts is to inflate them away through currency devaluation. The indebted and moribund US economy needs inflation, particularly now.

The price dynamics of precious metals and the hard commodities will answer the inflation question in due course. In fact we think it is already being answered. In any event investors must — I stress must — acquire a core holding in the commodity sector and particularly in gold and silver. This might be established in exchange traded funds, large cap commodity equities (such as Freeport McMoRan and
Goldcorp
) or directly in physical ownership of the metals.

In Friday’s action gold and silver fell slightly. Apparently the messages by Messrs. Summers, Geithner and Bernanke last Thursday rang hollow. Since October 1, gold has risen by 5% and silver by 8.3%. In the past 3 months, gold has risen 13.37%. The gold to silver ratio fell another 4% in favor of silver.

It is also clear that it is not the US, but her trading partners who must deal with the inevitable question of fiat currency policy and specifically the relative strength of their currencies.

The US in turn must deal with her budget deficit. The Obama Administration does not seem to realize this. Citizens around the world have complained about the American consumer’s debt addiction but not their proclivity to consume as the current credit crisis has evolved. By 2006 the US consumer comprised 20% of world GDP. This is now the global trap that requires significant restructuring.

Unfortunately Washington has decided to solve its current problems by prolonging the debt binge — this time by the government using the printing press. All this is a recipe for a weaker currency and stronger precious metals and commodity prices. The side effects that follow use of the printing press, particularly for a “reserve currency” and inevitable monetization, are global and can be harsh. Weimar Germany comes to mind with its printing-press-induced hyperinflation.

Currency realignments are in order. More important, currency stability is required. With the world’s energy systems about to change dramatically, US health care changes worth a trillion dollars and tough new regulations on the capital, commodity and credit markets something has to give. Alas it will be the dollar that gives in the longer run. No country can spend forever while financed almost entirely through debt creation. Eventually the global currency markets will force a restraint on US fiscal plans.

The precious metals markets have been predicting this outcome for years. Americans have not listened. Examine the following table of the total returns of gold in 13 different currencies, courtesy of Kitco. These are holding period total returns stated in percent. It is obvious that gold has been a stellar performer in almost all holding periods for most currencies. In US dollars gold provided a total return of 226 % over the past ten years and 148 % over the past 5. This equals compound average annual returns of 12.54% and 20.0% respectively. Does anyone know an investment compounding 20% each year on average for the past 5 years and 12.54% for the past 10 years?

In all but two holding periods above gold provided significant positive returns. Especially interesting, golds returns in British Pounds, Russian Rubles, Mexican Pesos, Indian Rupees, and South African Rand were extremely high. This is the fiat currency protection of gold, I keep teaching. Finally, it is noteworthy that during the last 30 and 60 days gold returns have been positive in all 13 country currencies.

Silver has been a better performer. During the last ten years silver has risen from a low point of $4.02 per ounce to its current level of $17.70, a 340.3% total return (16% average annual rate of return). Silver outperformed gold by more than 100%. We expect that outperformance to continue.

On Friday I listened with fascination to a presentation by commodity guru Jim Rogers. Jim is very bullish on China, the commodity cycle and believes that silver is severely undervalued. In 1968 I went to school in China, I have seen the tremendous progress and energy of the Chinese people. There is a nascent quality of life cycle brewing in China and the emerging world that will forge a continuation of the commodity cycle. Chinas most precious asset its human capital is unleashed. China recently opened the investment potential of silver to its citizens. We think demand for both gold and silver shall increase accordingly particularly in light of the current distrust of the dollar.

Mr. Rogers also thinks water and food are commodities of interest because they will become scarce in the next decade. There is already a dangerous scarcity of water for many alternative energy applications. In fact Mr. Rogers expresses deep concerns about the availability of water and food in the emerging world. I am planning a research effort on those commodities for another day. In the meantime please have a look at
Silver Wheaton
and
Endeavour Silver
. Both have significant leverage to silver and we think they are undervalued. As always please perform your own due diligence. Regarding the purchase of silver stocks obviously silver has had a nice run. We think that silver has $25 per ounce upside in the next 12 months based on the dollar potential discussed above. Silver is often referred to as “poor man’s gold.” I would be a buyer of silver ETFs on any pullback in the price of the metal.

Finally having sung the praises of the precious metals and the woes of the dollar I think there is entirely too much enthusiasm for the metals. In fact the euphoria for gold is downright frightening. I think a pullback in both gold and silver is in order. Such an event would be a buying opportunity for you particularly in silver and silver stocks.